Don't get burned by hot 3D stocks

Opinion: Industry will undoubtedly grow, but for now, stay out of the space

By

NigamArora

Bloomberg

A visitor watches a 3-D printer building an object during the 3-D Print show at the Business Design Center in London, U.K.

New York (MarketWatch) — It's no secret that 3D printing is hot. Stocks in the space have been the favorite of momentum investors. There is no doubt that 3D printing will grow, but investors buying public stocks at exorbitant prices will get burned.

The process consists of laying successive layers of material to form a solid object. Since its invention in 1980s, the industry was comparatively moribund until recent years when it caught fire due to a drop in printer prices and better software.

Bubble in 3D stocks

These stocks are expensive. Since many of the public 3D companies do not have meaningful earnings, take a look at their price/sales (P/S); Voxeljet
VJET, +0.00%
trades at a P/S of 19, Organovo
ONVO, +0.30%
a P/S of 13,444, 3D Systems
DDD, -4.98%
a P/S of 11, ExOne
XONE, +0.10%
P/S of 12, and Stratasys
SSYS, -5.94%
a P/S of 10.

Revenue and earnings from these companies over the last few quarters have consistently been below consensus estimates. Typically, these stocks dip temporarily on bad earnings and then bulls run them right back up. They have become cult stocks. Hope springs eternal as gurus and analysts often come out in droves to defend these stocks on bad earnings.

Why the gurus have it wrong

These are early days for 3D printing, it is common for companies in new fields to have high valuations justified by expectations that such companies will grow into their valuations.

The issue with 3D is that the earnings models of many of the popular gurus are just plain wrong. These companies have a “razor and blade” model. Bulls readily concede that over a period of time, printers will be commoditized and profit margins on printers will be razor thin.

Gurus’ earnings models assume high-margin materials and supplies sales. After all there is precedence; the likes of Hewlett Packard
HPQ, -0.33%
generate most of their profits not on printer sales, but on ink sales to consumers.

In the case of 3D printing, broadly speaking, there are three segments: consumer, professional and industrial. In spite of the hype, I do not think 3D printers are not going to become a mainstream consumer appliance anytime in the next five years.

In my opinion, sales to the professional segment should boom quickly. An example is an architect printing a 3D model of his new design to show to a client. The total potential revenue in this segment is only a very small fraction of the total 3D sales projected by the bulls.

I believe a vast majority of sales will be to the industrial segment. I think there are two ways gurus go wrong in their analysis of the industrial segment. First, they assume a high-margin supplies business. Such an assumption is a result of naivety about procurement practices in manufacturing. They are well intentioned, but they typically have financial backgrounds and no knowledge of how aggressively companies such as General Electric
GE, -0.08%
and General Motors
GM, -1.25%
squeeze their suppliers. The reality is that supplies will also rapidly become low-margin businesses.

Second, some gurus’ show a remarkable lack of knowledge about manufacturing processes in proclaiming that 3D printing will take over most of the manufacturing. It is a given that in due course, 3D printing will become the primary process for prototyping and low-volume batch production. However, 3D printing is at least a decade away from taking over mass production. 3D printers are simply too slow and too expensive for volume manufacturing. As time passes, 3D printers will become faster, but so will traditional manufacturing processes such as CNC machining and injection molding.

Not investable, but tradable

At present valuations, these stocks are not investable from the long side. However, they present opportunities from the short side. Due to the high short interest and resulting short squeezes in these stocks, only those with experience should consider shorting these stocks. As a learning tool, the two charts illustrate the present short positions of The Arora Report subscribers.

There are two technical indicators in the public domain that anyone can use that have been helpful in this trade. First notice peaks in ADX in the lower pane of the chart. Second, notice the start of a bigger divergence between 2 Time Series Forecasts (TSF). Cyan TSF is calculated based on the bar highs. Orange TSF is calculated based on bar lows.

Our second short position is in Proto Labs
PRLB, +0.92%
Notice on the chart that DDD shown in yellow had fallen, but PRLB had not. DDD is a popular stock, PRLB is relatively obscure. One of the time-tested principles is that when a general falls, soldiers often retreat. The addition to the short sale was made after listening to the earnings conference call on Feb. 11, 2014. Bulls were putting a positive spin on below-par earnings; the strength in the stock was an opportunity to go short.

Disclosure: Subscribers to The Arora Report have short positions in DDD and PRLB.

Nigam Arora is an engineer, nuclear physicist, author, and entrepreneur and the founder of two Inc. 500 fastest growing companies. He is also the developer of theZYX Change Methodto profit from change by investing. Arora is the chief investment officer atThe Arora Reportand the editor of four newsletters that track the ZYX Change Method. Nigam can be reached at Nigam@TheAroraReport.com

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